I’ve been thinking a lot lately about the types of investments that offer the best risk adjusted returns in this environment. One of the toughest things to evaluate today, and perhaps the most important when investing in stocks, is the sustainability of a company’s business model, cash flows and profits. Technology continues to change things at a rapid pace. It has accelerated the rate at which competitors pop-up by lowering barriers to entry in many industries. Competition is wonderful for consumers because it means lower prices but it’s a monkey wrench when trying to assess the long-term sustainability of a company. This is why food is one of my favorite investment themes. I have the clarity of knowing that the industry isn’t going to disappear anytime soon.
You may not know this about me but I am severely lactose intolerant so I eat eggs every morning for breakfast. I love eggs… they are delicious, nutritious, and a relatively cheap source of protein. If you think about it, eggs really don’t have a substitute and are cheap enough that consumers are relatively insensitive to price changes (outside of the Avian Flu issue last summer which caused the price of eggs to double. People do notice a 100% increase… but now egg prices are back to normal levels).
The sustainability of cash flows over time for egg producers/farms is quite strong but there are things you have to give up for that clarity, one being control over prices. Food prices are cyclical and often are not in the control of the producers. This means you want to stick with the companies that have the largest economies of scale and lowest production costs, which is usually the largest players in an industry. One of these companies is the newest stock I have purchased in portfolios – Cal-Maine Foods (CALM) – the largest producer of fresh shell eggs in the US with almost 25% market share. They sell their eggs under brands like Egg-Land’s Best, Land O’ Lakes, Farmhouse, and 4-Grain.
The Egg Market
The average per capita consumption in the US is about 250 eggs per year and egg consumption trends have been slowly increasing the past 15 years. Some of the most common breakfast foods are still pancakes, waffles, bagels and grain-heavy cereals (all carb and sugar heavy). As consumers are becoming more health conscious, we’re seeing a larger focus on protein which has led to an increase in egg consumption.
Over the past few years, the largest increases in egg consumption have been in specialty eggs like organic, cage-free and free-range. These categories make up about 20% of Cal-Maine’s sales but represent the bulk of revenue growth so this has been a key focus of investment. Specialty eggs typically sell for about 25% more than standard white eggs.
Run like a privately-held family business
Just over 40% of the company is owned by company executives and employees with about 35% (a small $700 million…) owned by the company’s founding family. The current Chairman and CEO, Adolphus Baker, is the son-in-law of the company’s founder and owns about $75 million of stock himself. This is exactly what I want to see as a shareholder. This gives me the confidence in knowing that management will take a conservative, long-term view and will always do what’s best for the company and shareholders.
Cal-Maine has a strong track record of acquisitions and lately they’ve been focusing on strategic joint-ventures associated with their investments in expanding specialty egg production. With egg prices now down to the lowest level in years, Cal-Maine could have an opportunity to buy smaller producers that don’t have the same economies of scale and are hurting from lower revenue.
The Financials
Let’s talk about some of the reasons that I’m attracted to CALM as an investment. The company currently has $387 million of cash on the balance sheet and only $21 million of long-term debt (net cash of $366 million) with an enterprise value of $1.85 billion. I expect the company to generate around $200 million of free cash flow over the next year. Revenue/profits vary each year with egg prices, which are largely affected by industry supply, so the company has a variable dividend policy where they return one-third of quarterly profits as a dividend. This absolutely makes sense and I’m surprised that more companies don’t have a policy like this. I also think the company is reaching the point where they enough extra free cash flow that I wouldn’t be surprised to see Cal-Maine return more cash to shareholders by either raising the dividend payout to maybe 50% or opportunistically look to repurchase stock.
Investing in Food & the Ability to Generate Investment Income
I could make the case that everyone should have food related investments in their portfolio since everyone eats food, but I think this especially makes sense for retirees. With inflation being one of the biggest risks in retirement, it’s important that a retiree is able to increase their investment income over time to keep pace. With Cal-Maine’s variable dividend policy, the income coming in will match changes in chicken and egg prices. If another outbreak, like the Avian Flu we saw last summer, hurts the chicken population, chicken and egg prices will rise. But higher egg prices mean higher profits for Cal-Maine and thus higher dividend income for us which can be used to cover the higher grocery bills.
Another thing that I love about stocks in general is that shareholders have the ability to produce additional income beyond the profits of the company by selling covered call options. Cal-Maine has an extremely high short-interest ratio at just over 50%. This means that a lot of hedge funds are betting against the stock. They’ve done this quite a bit in the past after big moves higher in the stock price, as we saw last year. It makes sense because Cal-Maine’s stock largely tracks egg prices and commodities are self-correcting, meaning big increases in price lead to increased supply which then lowers price back toward long-term averages. With egg prices down a lot in the last year and the stock now off about 25% from it’s high, I would imagine we start to see the short interest start to come down which should begin to support the stock (although I wouldn’t be surprised to see it move lower toward $40/share where I’ll likely buy more). Stocks with high short-interest ratios tend to be volatile which means that option premiums are elevated. This is good for us because it means we collect more income when selling options in addition to the dividend. I don’t care about the volatility in the price of the stock; it will trend higher given enough time. I’m focusing on the income we can generate by owning it which we can then use to buy more shares if/when the stock does drop.
Here’s Cal-Maine’s recent investor presentation which breaks down more info on the company.
Cal-Maine Foods (CALM) – 1 year
Cal-Maine Foods (CALM) – 10 years
Thanks for following!
-Nick
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